Capital Structure Mastery Lesson 04

Lesson Four: Preferred Equity

It is important to remember that not all equity is created equal. In this lesson, we will focus in the different types of preferred equity. To begin, we will focus on Sponsor Equity.

4.1 Sponsor Equity

There are three types of sponsor equity: Hard Cash Equity, Imputed Equity or Market Equity, and Syndicated Equity. Hard cash equity is preferred to imputed or syndicated equity, because cash equity allows the strongest alignment of interests.

Market equity is equity implicit within the asset, based on market value. For example, market equity could be based on purchasing the asset at a steep discount in relation to current market value.

When working with syndicated equity, one should be wary of sponsors who use other people’s money for their equity. Be prepared to ask the hard questions:

  1. Where is the equity coming from?
  2. How much direct equity is the sponsor contributing?
  3. If the sponsor is using other people’s money for equity, whose is it?
  4. How is the sponsor promoting the other equity?

There are three sources of syndicated equity. The first source is friends and family. Be very cautious here! While this is the easiest money for the investor to raise with the least amount of due diligence, it also means the investor will have to face family and friends if the deal goes bad. The second source is institutional money. This is better than sourcing through friends and family. Institutional money is harder to raise and will provide some backstopping should problems arise. The third source is pure syndication. This occurs in transactions such as Tenant in Common transactions, when a sponsor raises 100% of the required equity from people with whom they have no relationship. All investors, in this case, are passive. Sometimes sponsors collect a fee at closing and have no money in the transaction.

It is important to consider the pros and cons of sponsor equity. There are six reasons to consider transactions not involving a significant amount of hard equity.

  1. Cash flow in the deal is very strong.
  2. There is a significant imputed equity in the transaction, which gives the investor comfort that the sponsor will not walk away from the deal. Imputed equity is a result of market appreciation or loan amortization.
  3. The sponsor provides strong guarantees.
  4. The sponsor agrees to provide additional collateral.
  5. Great upside. (The greed factor is always at play!)
  6. Inside market information (you know something the market does not know).
4.2 Equity Investment Analysis

In real estate, there will always be good deals and bad deals—the key is to stay away from the bad ones. There are three ways to determine whether a potential deal is good or badl: Internal Rate of Return (IRR), Whole Dollar Profit, and Cash Flow.

Most equity transactions are measured by IRR. The IRR calculates that annualized rate of return on the equity investment. The IRR is measured by the following:

  1. Initial investment
  2. Cash flow or dividends received during the holding period.
  3. The terminal value or exit value (return of and return on capital) received at the end of the holding period or sale of the asset.

Whole dollar profit is the total amount of return on capital or dollar profit received by the investor. This is typically measured as a multiple of the original investment. Most investors look for a doubled return on an equity investment (or a doubled return on their money).

 

The final consideration is how dividend cash flow compares to terminal value cash flow. This is the percentage paid as dividend or cash flow during the holding period versus proceeds received either at the time sale or at an exit event. The investor needs to look closely at the amount of cash flow they will receive during the term of investment versus at exit. The greater the percentage that can be achieved during the term of the investment, the lower the risk the investor to takes on.

4.3 Defaults and the Equity Investor

 

In a default or bankruptcy situation, the say or rights of the equity investors are governed by a Partnership Agreement. There are two types of partners: general partners and limited partners. In the case of a loan default, general partners, who are typically large equity investors, become managing partners. They are then granted rights to decision-making. Conversely, limited partners have little to no say in plans or resolutions when a loan defaults. Limited partners take on the most risk.

Every investor needs to understand what their rights and remedies are in the event of project bankruptcy. In a default situation, lenders, creditors, and equity partners look to the character of the sponsor. In these situations, disposition, reputation, and behavior are paramount. If sponsors take a cooperative approach to help fix the problem, they stand a better chance of being treated well by lenders. Alternatively, if sponsors take a combative approach, they risk an all-out fight with the lenders.  

In difficult times, lenders look for problem-solvers. The actions of a borrower are differentiated by how much equity they are perceived to have remaining in the asset, as well as the degree of “leniency” the lender shows in restricting the loan to allow the borrower to recapture equity.

4.4 Preferred Equity Security/Collateral

Next up on the capital stack after the mezzanine debt is preferred equity transactions. In some cases, preferred equity is used in place of mezzanine debt when mezzanine debt is not allowed. Preferred equity is similar to mezzanine debt, albeit with no security; thus, it is an equity product.

In terms of security/collateral, the most significant difference here is that the mezzanine investor is secured by an Assignment of Partnership Interests. The preferred equity investor is unsecured, and they rely on the Partnership Agreement to determine their rights and benefits. Additionally, there is no Intercreditor Agreement. The first trust lender is not party to the transaction.

When considering repayment, this can be significant if the transaction has both mezzanine debt and preferred equity. In both cases, mezzanine debt and preferred equity must be paid prior to equity receiving any of its principal balance. The interest rate and the preferred return are typically the same between preferred equity and mezzanine debt. The rate or preference is the current or accrued “pay rate” that must be totally repaid (principal and interest) to the investor first, before returning capital. Most preferred equity profit participation is in the form of a fixed return, such as a 9% preferred return and a lock back IRR to 15%.

When a default occurs, there are remedies for the preferred equity investor to take. In a preferred equity transaction, remedies run to the General Partner and not to the property. The typical remedy is dilution of the General Partnership’s economic interests and/or their ability to manage or control the property.

Below is a table that compares mezzanine financing and preferred equity financing:

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